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C r it ic a l C o n c e pt s f o r t h e 2 0 19 C F A ® Ex a m

ETHICAL AND PROFESSIONAL STANDARDSI Professionalism1(A) Knowledge of the Law.1(B) Independence and Objectivity.1(C) Misrepresentation.1(D) Misconduct.II Integrity of Capital Markets 11(A) Material Nonpublic Information.11(B) Market Manipulation.III Duties to ClientsIII (A) Loyalty, Prudence, and Care.III(B) Fair Dealing.III(C) Suitability.III(D) Performance Presentation.III(E) Preservation of Confidentiality.IV Duties to Employers IV(A) Loyalty.IV(B) Additional Compensation Arrangements. IV(C) Responsibilities of Supervisors.V Investment Analysis, Recommendations,

and ActionsV(A) Diligence and Reasonable Basis.V(B) Communication with Clients and

Prospective Clients.V(C) Record Retention.VI Conflicts of Interest VI(A) Disclosure of Conflicts.VI (B) Priority of Transactions.VI(C) Referral Fees.VII Responsibilities as a CFA Institute

Member or CFA CandidateVII(A) Conduct as Participants in CFA Institute

Programs.VII(B) Reference to CFA Institute, the CFA

Designation, and the CFA Program.Global Investment Performance Standards(GIPS®)

• Compliance statement: “[Insert name of firm] has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS).” Compliance must be applied on a firm-wide basis.

• Nine sections: fundamentals of compliance, input data, calculation methodology, composite construction, disclosures, presentation and reporting, real estate, private equity, and wrap fee/separately managed account portfolios.

QUANTITATIVE METHODSTime Value of Money Basics• Future value (FV): amount to which investment

grows after one or more compounding periods.• Future value: FV = PV(1 + I/Y)N.• Present value (PV): current value of some future

cash flow PV - FV/(1 + I/Y)N.• Annuities: series of equal cash flows that occur at

evenly spaced intervals over time.• Ordinary annuity: cash flow at end-oFume. period.• Annuity due: cash flow at beginning-of-time period.• Perpetuities: annuities with infinite lives.

PV . = PMT/(discount rate).perpetuity v

Required Rate o f ReturnComponents:1. Real risk-free rate (RFR).2. Expected inflation rate premium (IP).3. Risk premium.

E(R) = (1 + RFRreal)(l + IP)(1 + RP) — 1

Approximation formula for nominal required rate:E(R) = RFR + IP + RP

MeansArithmetic mean: sum of all observation values in sample/population, divided by # of observations. Geometric mean: used when calculating investment returns over multiple periods or to measure compound growth rates.Geometric mean return:

Y*Rc= [(l + R1)x . . .x ( l + RN)]/N — 1

harmonic mean =N

N

Ei=l , x [ ,

Variance and Standard DeviationVariance: average of squared deviations from mean.

N

£ ( Xi— M)2population variance = cr2 = — --------------

N

n

E ( x i - x ) 2sample variance = s =2 i=l

n — 1Standard deviation: square root of variance. Holding Period Return (HPR)

R Pr-Pr-t+ D r or _ !Pt-1 Pt-1

Coefficient of VariationCoefficient o f variation (C V): expresses how much dispersion exists relative to mean of a distribution; allows for direct comparison of dispersion across different data sets. CV is calculated by dividing standard deviation of a distribution by the mean or expected value of the distribution:

CV = =X

Sharpe RatioSharpe ratio: measures excess return per unit of risk.

c, • rP - r fbnarpe ratio = —------a„

Roy's safety-first ratio: rp t̂arget

For both ratios, larger is better.Expected Return/Standard Deviation

Expected return : E(X) = ^ ^ P (x j) xn E(X) = P(x1)x 1+ P (x 2)x 2 + ... + P (xn)x n

Probabilistic variance:

^2( x ) = E p(xi ) h - E(x )f= P(x1)[x1- E ( X ) f + P (x2)[x2 -E (X ) ] :

+ .. . + P(xn)[x „ — E (x ) f

Standard deviation: take square root of variance.Correlation and CovarianceCorrelation: covariance divided by product of the two standard deviations.

corr R^R: =COV (R j, Rj

Expected return, variance o f 2-stock portfolio.

E (R P) = w a E(Ra ) + w bE(Rb)

var(R p) = w2 cr2 (R A) + w2cr2 (R B)+ 2w Aw Bcr(RA)cr(RB)p (R A,R B)

Normal DistributionsNormal distribution is completely described by its mean and variance.68% of observations fall within ± Ict.90% fall within ± 1.65a.95% fall within ± 1.96a.99% fall within ± 2.58a.Computing Z-ScoresZ-score: “standardizes” observation from normal distribution; represents # of standard deviations a given observation is from population mean.

observation — population meanz =

x — f lstandard deviation a

Binomial ModelsBinom ial distribution: assumes a variable can take one of two values (success/failure) or, in the case of a stock, movements (up/down). A binomial model can describe changes in the value of an asset or portfolio; it can be used to compute its expected value over several periods.Sampling DistributionSampling distribution: probability distribution of all possible sample statistics computed from a set of equal-size samples randomly drawn from the same population. The sampling distribution o f the mean is the distribution of estimates of the mean.Central Limit TheoremCentral lim it theorem: when selecting simple random samples of size n from population with mean p and finite variance a 2, the sampling distribution of sample mean approaches normal probability distribution with mean p and variance equal to a 1 In as the sample size becomes large.Standard ErrorStandard error o f the sample mean is the standard deviation of distribution of the sample means.

known population variance: a^ = a

unknown population variance: s* =

Confidence IntervalsConfidence interval: gives range of values the mean value will be between, with a given probability (say 90% or 95%). With known variance, formula for a confidence interval is:

x ± za

a l l

Z aJ2

Z =a ll

Z =a ll

1.645 for 90% confidence intervals (significance level 10%, 5% in each tail)1.960 for 95% confidence intervals (significance level 5%, 2.5% in each tail)2.575 for 99% confidence intervals (significance level 1%, 0.5% in each tail)

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QUANTITATIVE METHODS continued...Null and Alternative HypothesesNull hypothesis (H{)): hypothesis that contains the equal sign (=, <, >); the hypothesis that is actually tested; the basis for selection of the test statistics. Alternative hypothesis (Ha): concluded if there is sufficient evidence to reject the null hypothesis.Difference Between One- and Two-Tailed TestsOne-tailed test: tests whether value is greater than or less than a given number.Two-tailed test: tests whether value is equal to a given number.• One-tailed test: H0: p < 0 versus Ha: p > 0.• Two-tailed test: H0: p = 0 versus Ha p * 0.Type I and Type II Errors• Type I error: rejection of null hypothesis when it is

actually true.• Type II error: failure to reject null hypothesis when

it is actually false.Types of Hypothesis TestsUse t-statistic for tests involving the population mean (location of mean, difference in means, paired comparisons).Use chi-square statistic for tests of a single population variance.Use F-statistic for tests comparing two population variances.Technical AnalysisReversal patterns: head and shoulders, inverse H&S, double/triple top or bottom.Continuation patterns: triangles, rectangles, pennants, flags.Price-based indicators: moving averages, Bollinger bands, momentum oscillators (rate of change, RSI, stochastic, MACD).Sentiment indicators: opinion polls, put/call ratio, VIX, margin debt, short interest ratio.Flow o f fu nd s indicators: TRIN, margin debt, mutual fund cash position, new equity issuance, secondary offerings.

ECONOMICS1

Elasticity

Own p rice elasticity %A quantity demanded %A price

If absolute value > 1, demand is elastic.If absolute value < 1, demand is inelastic.On a straight line dem and curve, total revenue is maximized where price elasticity = — 1.

%A quantity demanded%A income

If positive, the good is a normal good.If negative, the good is an inferior good.

. . . . %A quantity demandedCross p r ice elasticity = ---------------------------------%A price of related good

If positive, related good is a substitute.If negative, related good is a complement.Breakeven and ShutdownBreakeven: total revenue = total cost.Operate in short run if total revenue is greater than total variable cost but less than total cost.Shut down in short run if total revenue is less than total variable cost.

Incom e elasticity

Market StructuresPerfect competition: Many firms with no pricing power; very low or no barriers to entry; homogeneous product.M onopolistic competition: Many firms; some pricing power; low barriers to entry; differentiated products; large advertising expense.

Oligopoly: Few firms that may have significant pricing power; high barriers to entry; products may be homogeneous or differentiated.Monopoly: Single firm with significant pricing power; high barriers to entry; advertising used to compete with substitute products.In all market structures, profit is maximized at the output quantity for which marginal revenue = marginal cost.Gross Domestic ProductReal GDP = consumption spending + investment + government spending + net exports.Savings, Investment, Fiscal Balance, and Trade BalanceFiscal budget deficit (G - T) = excess of saving over domestic investment (S - I) - trade balance (X - M)Equation of ExchangeMV = PY, where M = real money supply, V = velocity of money in transactions, P = price level, and Y = real GDP.Business Cycle PhasesExpansion; peak; contraction; trough.Economic IndicatorsLeading: Turning points occur ahead of peaks and troughs (stock prices, initial unemployment claims, manufacturing new orders)Coincident: Turning points coincide with peaks and troughs (nonfarm payrolls, personal income, manufacturing sales)Lagging: Turning points follow peaks and troughs (average duration of unemployment, inventory/ sales ratio, prime rate)Factors Affecting Aggregate DemandConsumers’ wealth; business expectations; consumers’ income expectations; capacity utilization; monetary and fiscal policy; exchange rates; global economic growth.Factors Affecting SR Aggregate SupplyInput prices; labor productivity; expectations for output prices; taxes and subsidies; exchange rates; all factors that affect LR aggregate supply.Factors Affecting LR Aggregate SupplySize of labor force; human capital; supply of natural resources; stock of physical capital; level of technology.Typ es of UnemploymentFrictional: time lag in matching qualified workers with job openings.Structural: unemployed workers do not have the skills to match newly created jobs.Cyclical: economy producing at less than capacity during contraction phase of business cycle.Policy Multipliers

money multiplier = --------------- ----------reserve requirement

fiscal multiplier = --------------------l - M P C ( l - t )

where MPC = marginal propensity to consume, t = tax rate.Expansionary and Contractionary PolicyM onetary po licy is expansionary when the policy rate is less than the neutral interest rate (real trend rate of economic growth + inflation target) and contractionary when the policy rate is greater than the neutral interest rate.Fiscal po licy is expansionary when a budget deficit is increasing or surplus is decreasing, and contractionary when a budget deficit is decreasing or surplus is increasing.

Balance of PaymentsCurrent account: merchandise and services; income receipts; unilateral transfers.Capital account: capital transfers; sales/purchases of nonfinancial assets.Financial account: government-owned assets abroad; foreign-owned assets in the country.Regional Trading AgreementsFree trade area: Removes barriers to goods and services trade among members.Customs union: Members also adopt common trade policies with non-members.Common market: Members also remove barriers to labor and capital movements among members. Economic union: Members also establish common institutions and economic policy.M onetary union: Members also adopt a common currency.Foreign Exchange RatesFor the exam, FX rates are expressed as p rice currency / base currency and interpreted as the number of units of the price currency for each unit of the base currency.Real Exchange Rate

base currency CPI= nominal FX rate X

price currency CPI y

No-Arbitrage Forward Exchange Rate

forward 1 + price currency interest ratespot 1 + base currency interest rate

Exchange Rate RegimesFormal dollarization: country adopts foreign currency.M onetary union: members adopt common currency. Fixed p eg: ± 1 % margin versus foreign currency or basket of currencies.Target zone: Wider margin than fixed peg.Crawling p eg : Pegged exchange rate adjusted periodically.Crawling bands: Width of margin increases over time.M anaged floa ting: Monetary authority acts to influence exchange rate but does not set a target. Independently floa ting: Exchange rate is market- determined.

F in a n c ia l r e p o r t in g a n d.ANALYSIS

Revenue RecognitionTwo requirements: (1) completion of earnings process and (2) reasonable assurance of payment.Revenue Recognition Methods• Percentage-of-completion method.• Completed contract method.• Installment sales.• Cost recovery method.Converged Standards Issued May 2014Five-step revenue recognition model:1. Identify contracts2. Identify performance obligations3. Determine transaction price4. Allocate price to obligations5. Recognize when (as) obligations are satisfiedUnusual or Infrequent Items• Gains/losses from disposal of a business segment.• Gains/losses from sale of assets or investments in

subsidiaries.• Provisions for environmental remediation.

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FINANCIAL REPORTING AND ANALYSIS continued...

• Impairments, write-offs, write-downs, and restructuring costs.

• Integration expenses associated with businesses recently acquired.

Discontinued OperationsTo be accounted for as a discontinued operation, a business—assets, operations, investing, financing activities—must be physically/operationally distinct from rest of firm. Income/losses are reported net of tax after net income from continuing operations.Compute Cash Flows From Operations (CFO)Direct m ethod : start with cash collections (cash equivalent of sales); cash inputs (cash equivalent of cost of goods sold); cash operating expenses; cash interest expense; cash taxes.Indirect method: start with net income, subtracting back gains and adding back losses resulting from financing or investment cash flows, adding back all noncash charges, and adding and subtracting asset and liability accounts that result from operations.Free Cash FlowFree cash flow (FCF) measures cash available for discretionary purposes. It is equal to operating cash flow less net capital expenditures.Critical RatiosCommon-size fin an cia l statem ent analysis:• Common-size balance sheet expresses all balance

sheet accounts as a percentage of total assets.• Common-size in com e statement expresses all

income statement items as a percentage of sales.• Common-size cash flow statement expresses each

line item as a percentage of total cash inflows (outflows), or as a percentage of net revenue.

Horizontal common-size finan cia l statement analysis: expresses each line item relative to its value in a common base period.Liquidity ratios:

current assetscurrent ratio = ----------- -—7-77—

current liabilitiescash + marketable securities + receivables

current liabilities

cash + marketable securities current liabilities

. . . . . cash + mkt. sec. + receivablesdefensive interval = ------- -------------------- -----------

daily cash expenditures

Receivables, inventory, payables turnover, and days' supply ratios—all o f which are used in the cash conversion cycle:

. . . annual salesreceivables turnover = ------------------------

quick ratio =

cash ratio =

inventory turnover =

average receivables

cost of goods sold average inventory

payables turnover ratio =purchases

average trade payables

days of sales outstanding = 365

days of inventory on hand = 7

receivables turnover

365

number of days of payables =

inventory turnover

365payables turnover ratio

cash conversion cycle =days of inventory

on hand

+days of sales number of daysoutstanding of payables

Total asset, fixed-asset, and working capital turnover ratios:

total asset turnover =revenue

average total assets

fixed asset turnover =revenue

average fixed assets

working capital turnover =revenue

average working capital

Gross, operating, and net p ro fit margins:

f, . gross profit gross profit margin = --------------

revenue

. operating profit EBIT operating profit margin = ------------ --------—

revenue net sales

net incomenet profit margin =

revenueReturn on assets [return on total capital (ROTC)J:

return on assets _ EBIT(total capital) average total capital

Debt to equity ratio and total deb t ratio:total debt

debt-to-equity ratio =total equity

total-debt-ratio =total debttotal assets

Interest coverage and fix ed charge coverage:EBIT

interest coverage = 7interest

f, . . EBIT + lease paymentsfixed charge coverage = --------------------1------------

interest + lease payments

Growth rate (g): g = RR x ROE

dividends declaredretention rate — 1 —operating income after taxes

Liquidity ratios indicate company’s ability to pay its short-term liabilities.Operating perform ance ratios indicate how well management operates the business.DuPont AnalysisTraditional DuPont equation:

return on equity =net income sales assets

k sales kassets, , equity,

net profit asset equitymargin turnover/ multiplier

You may also see it presented as:

return on equity =

Extended DuPont equation further decomposes net profit margin:

ROE =net income

v ' EBT v' EBIT '

EBT /A

EBITV /A

revenue

x revenuev

avg. total assetsavg. total assets

Aavg. equity

You may also see it presented as:ROE = tax burden x interest burden x

EBIT margin x asset turnover x leverageMarketable Security ClassificationsHeld-for-trading: fair value on balance sheet; dividends, interest, realized and unrealized G/L recognized on income statement.Available-for-sale: fair value on balance sheet; dividends, interest, realized G/L recognized on income statement; unrealized G/L is other comprehensive income.

Held-to-maturity: amortized cost on balance sheet; interest, realized G/L recognized on income statement.Inventory AccountingIn periods of rising prices and stable or increasing inventory quantities:

LIFO results in : FIFO results in :Higher COGS Lower COGSLower gross profit Higher gross profitLower inventory Higher inventorybalances balances

Basic and Diluted EPSBasic EPS calculation does not consider effects of any dilutive securities in computation of EPS:

net income — preferred dividendsbasic EPS =

wtd. avg. no. of common shs. outstanding

... . adj. income avail, for common sharesdiluted EPS = ---- --------------------------------------------—

wtd. avg. common shares plus potential common shares outstanding

Therefore, diluted EPS is:

net _ pfd income div

convertible + preferred +

dividends

convertible' debt

interest(1-t)

wtd shares from sh ’ s from sharesaw sh s

+ conversion of conv. pfd. sh’s

+ conversion conv. debt

+ issuable from stock options

Long-Lived Assets Capitalizing vs. ExpensingCapitalizing: lowers income variability and increases near-term profits. Increase assets, equity. Expensing: opposite effect.Depreciation

cost — residual valueStraight-line: ----------------------------

useful lifeDouble d eclin ing balance:

(cost — accum. depreciation)Vuseful life /

Units o f production :cost — salvage value * •

useful life in unitsx output units

Revaluation of Long-Lived AssetsIFRS: revaluation gain recognized in net income only to the extent it reverses previously recognized impairment loss; further gains recognized in equity as revaluation surplus. (For investm ent property, all gains and losses from marking to fair value are recognized as income.)U.S. GAAP: revaluation is not permitted.Deferred Taxes• Created when taxable income (on tax return) ^

pretax income (on financial statements) due to temporary differences.

• D eferred tax liabilities are created when taxable income < pretax income. Treat DTL as equity if not expected to reverse.

• D eferred tax assets are created when taxable income > pretax income. Must recognize valuation allowance if more likely than not that DTA will not be realized.

Long-Term Liabilities• Premium bond: coupon rate > market rate at

issuance.• Discount bond: coupon rate < market rate at

issuance.• Interest expense equals book value at the beginning

of the year multiplied by the market rate of interest at the time the bonds were issued.

FINANCIAL REPORTING AND ANALYSIS continued.• •

LeasesFinancial statement/ratio impact of lease accounting from the lessee perspective: capital leases result in:• Higher: assets, liabilities, CFO, debt/equity.• Lower: net income (early years), CFF, current

ratio, working capital, asset turnover, ROA,ROE.

• Same: total cash flow.PensionsD efined contribution: employer contribution expensed in period incurred.D efined benefit: overfunded plan recognized as asset, underfunded plan recognized as liability.

CORPORATE FINANCEWeighted Average Cost of Capital

WACC = (wd)[kd(l- t) ] + (wps)(kps) + (wce)(ks)

Cost o f Preferred Stock

P

Cost o f Equity Capital

■ D,k« = y i + s i 0

Cost of Equity Using CAPM

kc = RFR + /}(Rmkl - RFR)

Capital Budgeting

NPV - CF0 + CFl . + CFz „ + ...+ CFn(1 + k)1 (1 + k): (1 + k)n

IRR: discount rate that makes NPV equal to zero.Pure-Play Method Project BetaDelevered asset beta for comparable company:

13 asset Passet ^equity X

1 + (1-0 D

Relevered project beta for subject firm:D

P nroiecr ^project asset X i+ ( i - t )

Measures of LeverageTotal leverage: percent change in net income from a given percent change in sales.Operating leverage: percent change in EBIT from a given percent change in sales.Financial leverage: percent change in net income from a given percent change in EBIT.

breakeven quantity of sales = fixed operating & financing costs

price — variable costs per unit

operating breakeven quantity of sales = fixed operating costs

price — variable costs per unit

Working Capital ManagementPrimary sources ofiliquidity, cash balances, short-term funding, cash flow management of collections and payment.Secondary sources o f liquidity, liquidating assets, negotiating debt agreements, bankruptcy protection.

Cost of trade credit:

1 +% discount

l-% discount

365days past discount

Corporate GovernanceOne-tier board: Includes internal and external directorsTwo-tier board: Supervisory board of external directors, management board of internal directors Board committees:Audit: Financial reporting Governance: Legal and ethics compliance Nominations: Find Board candidates Remuneration: Compensation for senior managers Risk: Firm risk tolerance and risk management Investment: Review large capital projects, asset purchases, asset sales

PORTFOLIO MANAGEMENTInvestment Policy StatementInvestment objectives:• Return objectives.• Risk tolerance.Constraints:• Liquidity needs.• Time horizon.• Tax concerns.• Legal and regulatory factors.• Unique needs and preferences.Combining Preferences with the Optimal Set of PortfoliosMarkowitz efficient frontier is the set of portfolios that have highest return for given level of risk.

Security Market Line (SML)Investors should only be compensated for risk relative to market. Unsystematic risk is diversified away; investors are compensated for systematic risk. The equation of the SML is the CAPM, which is a return/systematic risk equilibrium relationship.

total risk = systematic + unsystematic risk

CAPM : E (R j) = RFR + (3- [E (Rmkt) - RFR]

E(R.)

The SML and EquilibriumIdentifying mispriced stocks:Consider three stocks (A, B, C) and SML. Estimated stock returns should plot on SML.• A return plot over the line is underpriced.• A return plot under the line is overpriced .

E(R)

Risk-Adjusted ReturnsSharpe ratio and M -squared measure excess return per unit of total risk.Treynor measure and Jensens alpha measure excess return per unit of systematic risk.

E(R)

SECURITIES MARKETS , & EQUITY INVESTMENTS

Well-Functioning Security Markets• Operational efficiency (lowest possible

transactions costs).• Informational efficiency (prices rapidly adjust to

new information).Margin PurchasesFor margin transactions:• Leverage factor = 1 /margin percentage.• Levered return = HPR x leverage factor.Margin Call Price

P0 (1 — initial margin %)1 — maintenance margin %

Securities Markets & Equity Investments continued... Computing Index Prices

„ . . , . T . stock pricesPrice-weighted Index = —-----------—----

adjusted divisor

Value-weighted Index

^(current prices) (# shares)= ------------------- ^ ---------------------------X base value

XXbase year prices) (# base year shares)

Types o f OrdersExecution instructions: how to trade; e.g., market orders, limit orders.Validity instructions: when to execute; e.g., stop orders, day orders, fill-or-kill orders.Clearing instructions: how to clear and settle; for sell orders, specify short sale or sale of owned security.Market StructuresQuote-driven markets: investors trade with dealers. Order-driven markets: buyers and sellers matched by rules.Brokered markets: brokers find counterparties.Forms of EMH• Weak form . Current stock prices fu lly reflect

available security market info. Volumeinformation/past price do not relate to futuredirection of security prices. Investor cannotachieve excess returns using tech analysis.

• Semi-strong form . Security prices instantly adjustto new pub lic information. Investor cannot achieve excess returns using fundamental analysis.

• Strong form . Stock prices fu lly reflect a llinformation from pub lic and priva te sources.Assumes p er fect markets in which all informationis cost free and available to everyone at the sametime. Even with inside info, investor cannotachieve excess returns.

. EQUITY INVESTMENTSIndustry Life Cycle StagesEmbryonic: slow growth, high prices, large investment needed, high risk of failure.Growth: rapid growth, falling prices, limited competition, increasing profitability.Shakeout: slower growth, intense competition, declining profitability, cost cutting, weaker firms fail or merge.Mature: slow growth, consolidation, stable prices, high barriers to entry.Decline: negative growth, declining prices, consolidation.Five Competitive Forces1. Rivalry among existing competitors.2. Threat of entry.3. Threat of substitutes.4. Power of buyers.5. Power of suppliers.One-Period Valuation Model

Pi(l + kc)

Be sure to use expected dividend Dj in calculation.Infinite Period Dividend Discount ModelsSupernormal grow th m odel (multi-stage) DDM:

V„ = D ,

(1 + k_)+ + D- + n

( i+ k e )n a + k er

where: P„ =Dn+ l

" ( k . - g e)

Constant grow th model:

y = Do(1 + gc) = Di0 ke “ gc

Critical relationship between k and g :• As difference between k and g c widens, value of

stock falls.• As difference narrows, value of stock rises.• Small changes in difference between k and g

cause large changes in stock’s value.Critical assumptions of infinite period DDM:• Stock pays dividends; constant growth rate.• Constant growth rate, g > never changes.• k must be greater than g c (or math will not work)Earnings Multiplier Model

Dio

Ej k -payout ratio

k ^

Price Multiples

leading P/E =price per share

trailing P/E =

forecast EPS next 12 mo,

price per share EPS previous 12 mo.

P/B =

P/S =

price per share book value per share

price per share sales per share

P/CF =price per share

cash flow per share

FIXED INCOMEBasic Features of BondsIssuer. Sovereign, non-sovereign, quasi-government, supranational, corporate, SPE.Maturity. Money market (one year or less); capital market (greater than one year).Par value. Bond’s principal value (face value). Coupon. Annual percent of par; fixed or floating. Divide by period icity to get periodic rate.Currency. Single, dual, currency option.Indenture. Affirmative and negative covenants.Price, Yield, Coupon RelationshipsBond prices and yields are inversely related.Increase in yield decreases price; decrease in yield increases price.Coupon < yield: Discount to par value.Coupon > yield: Premium to par value. Constant-yield p r ice trajectory: Price approaches par as bond nears maturity from amortization of discounts and premiums. Capital gains and losses are calculated relative to this trajectory.Cash Flow StructuresBullet: All principal repaid at maturity.Fully amortizing: Equal periodic payments include both interest and principal.Partially amortizing: Periodic payments include interest and principal, balloon payment at maturity repays remaining principal.Sinking fu n d : Schedule for early redemption. Floating-rate: Coupon payments based on reference rate plus margin.Bond PricingThere are two equivalent ways to price a bond:• Constant discount rate applied to all cash flows

(YTM) to find PV. This is a bond’s f la t p r ice (doesnot include accrued interest).

• Discount each cash flow using appropriate spotrate for each. This is a bond’s

includes accrued interest. Governmentbonds use actual day counts; corporate bonds use

full price = PV at last coupon date x (1 + YTM)r/T accrued interest = coupon payment x (t/T) where:t = days from most recent coupon payment to

trade settlementT = days in coupon payment period

Matrix pricing: For illiquid bonds, use yields of bonds with same credit quality to estimate yield; adjust for maturity differences with linear interpolation.Bond MarketsNational bond market includes domestic bonds and foreign bonds.• Domestic bonds. Domestic issuer and currency.• Foreign bonds. Foreign issuer, domestic currency.Eurobond market is outside any one country, with bonds denominated in currencies other than those of countries in which bonds are sold.Global bonds trade in both a national bond market and the eurobond market.Bond IssuanceUnderwritten offering: Investment banks buy entire issue, sell to public.Best efforts offering: Investment banks act as brokers. S helf registration: Register entire issue with regulators but sell over a period of time.Embedded OptionsCallable: Issuer may repay principal early. Increases yield and decreases duration.Putable: Bondholder may sell bond back to issuer. Decreases yield and duration.Convertible: Bondholder may exchange bond for issuer’s common stock.Embedded warrants: Bondholder may buy issuer’s common stock at exercise price.Yield MeasuresEffective y ie ld depends on periodicity. YTM = effective yield for annual-pay bonds.Semiannual bond basis: YTM = 2 x semiannual discount rate.Current y ie ld = annual coupon / price.Simple y ie ld = current yield ± amortization.Yield to ca ll is based on call date and call price.Yield to worst is lowest of a bond’s YTCs or YTM. M oney market yields may be on a discount or add­on basis and may use a 360- or 365-day year. Bond-equivalent y ie ld is an annualized add-on yield based on a 365-day year.Forward and Spot RatesForward rate is a rate for a loan that begins at a future date. “Iy3y” = 3-year forward rate 1 year from today.Example of spot-forward relationship:

(1 + s 2)2 = (1 + S ^ l + ly ly )Yield SpreadsG-spread: Basis points above government yield. I-spread: Basis points above swap rate.Z-spread: Accounts for shape of yield curve. Option-adjusted spread: Adjusts Z-spread for effects of embedded options.Interest Rate RiskInterest rate risk has two components: reinvestment risk and market price risk from YTM changes. These risks have opposing effects on an investor’s horizon yield.• Bond investors with short horizons are more

concerned with market price risk.• Bond investors with long horizons are more

concerned with reinvestment risk.• The horizon at which market price risk and

reinvestment risk just offset is a bond’s Macaulayduration. This is the weighted average of timesuntil a bond’s cash flows are scheduled to be paid.

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FIXED INCOME continued...

M odified duration is the approximate change in a bonds price given a 1% change in its YTM:

Macaulay duration (V_) — (V+ )~~ 0 + 0 2V0 (Ay)

Effective duration is required if a bond has embedded options:

( v _ ) - ( v + )

2 Vo (Acurve)

Price change estimates based on duration only are improved by adjusting for convexity:

1%Aprice = —duration (A y) H— convexity (Ay)'

Asset-Backed SecuritiesResidential MBS', home mortgages are collateral. Agency RMBS include only conforming loans; nonagencv RMBS may include nonconforming loans and need credit enhancement.Prepayment risk-, contraction risk from faster prepayments; extension risk from slower prepayments.CMOs: pass-through MBS are collateral. May have sequential-pay or PAC/support structure. Commercial MBS: non-recourse mortgages on commercial properties are collateral.Auto ABS: auto loans are collateral.Credit card ABS: credit card receivables are collateral.CDOs: Bonds, bank loans, MBS, ABS, or other CDOs are collateral.Collateral and Credit EnhancementSecured bonds are backed by specific collateral and senior to unsecured bonds.Unsecured bonds are general claims to issuer’s cash flows and assets.Internal cred it enhancement: Excess spread, overcollateralization, waterfall structure.External cred it enhancement: Surety bonds, letters of credit, bank guarantees.Credit AnalysisInvestm ent grade: Baa3/BBB- or above N on-investment grade: Bal/BB+ or below Corporate family rating (CFR): issuer rating. Corporate credit rating (CCR): security rating. “Four Cs”: capacity, collateral, covenants, character,

default risk = probability of default loss severity = percent of value lost if borrower

defaultsexpected loss = default risk x loss severity recovery rate = 1 - expected loss percentage

— .----------------- ------- . —

DERIVATIVESArbitrage and Replication• Law o f one p r ice : two assets with identical cash

flows in the future, regardless of future events,should have the same price.

• Two assets with uncertain returns can be combinedin a portfolio that will have a certain payoff. If aportfolio has a certain payoff, the portfolio shouldyield the risk-free rate. For this reason, derivativesvalues are based on risk-neutral pricing.

Forward Contract ValueAt time P.

Vt (T ) = St + PVt (cost) - PVt (benefit) - F0(T)(1 + Rf)T - t

At expiration (tim e t = T): payoff to long = ST - FQ(T)Futures vs. Forwards

ForwardsPrivate contractsUnique contractsDefault riskLittle or no regulation

FuturesExchange-traded Standardized contracts Guaranteed by clearinghouse Regulated

Forward Rate Agreements (FRA)Can be viewed as a forward contract to borrow/ lend money at a certain rate at some future date.Interest Rate SwapsMay be replicated by a series of off-market FRAs with present values at swap initiation that sum to zero.Options• Buyer of a call option—long asset exposure.• Writer (seller) of a call option—short asset

exposure.• Buyer of a put option—short asset exposure.• Writer (seller) of a put option—long asset

exposure.intrinsic value of a call option = Max[0, S — X] intrinsic value of a put option = Max[0, X - S]

American vs. European OptionsAmerican options allow the owner to exercise the option any time before or at expiration. European options can be exercised only at expiration. Value of American option will equal or exceed value of European option. They will have identical values except for: (1) call options on dividend paying stocks and (2) in-the-money put options.Factors that Afifect Option Values

Increase in: Calls Puts

Asset price Increase Decrease

Exercise price Decrease Increase

Risk-free rate Increase Decrease

Volatility Increase Increase

Time to Increase Increase*expiration

Holding costs Increase Decrease

Holdingbenefits

Decrease Increase

*Except some deep-in-the-money European puts.Put-Call ParityThe put-call parity relationship for European options at time t.

, ^ C ,Ct “1------------------t " --- b t + P t

(l + R f)T

ISBN: ^ 7 5 - 1 - 4 7 5 4 - 7 5 7 ^ - 2

ALTERNATIVE INVESTMENTSHedge FundsEvent-driven strategies: merger arbitrage; distressed/ restructuring; activist shareholder; special situations.Relative value strategies: convertible arbitrage; asset-backed fixed income; general fixed income; volatility; multi-strategy.Equity strategies: market neutral; fundamental growth; fundamental value; quantitative directional; short bias.Macro strategies: based on global economic trends. Hedge fund fees:• “2 and 20”: 2% management fee plus 20%

incentive fee.• Hard hurdle rate: incentive fee only on return

above hurdle rate.• Soft hurdle rate: incentive fee on whole return,

but only paid if return is greater than hurdle rate.• High water mark: no incentive fee until value

exceeds previous high.Private EquityLeveraged buyouts: management buyouts (existing managers), management buy-ins (new managers) Venture capital stages of development:• Formative stage: angel investing, seed stage, early

stage.• Later stage: finance product development,

marketing, market research.• Mezzanine stage: prepare for IPO.Portfolio company valuation methods: market/ comparables; discounted cash flow; asset-based.Exit strategies: trade sale; IPO; recapitalization; secondary sale; write-off.Real EstateIncludes residential property; commercial property; real estate investment trusts (REITs); farmland/ timberland; whole loans; construction loans.Property valuation methods: comparable sales; income approach; cost approach.CommoditiesContango-, futures price > spot price.Backwardation: futures price < spot price.Sources of investment return:• Collateral y ield : return on T-bills posted as margin.• Price return: due to change in spot price.• Roll yield : positive for backwardation, negative for

contango.futures price « spot price(l + Rf) + storage costs - convenience yield

InfrastructureLong-lived assets for public use, including transportation, utility, communications, social Brownfield: Existing infrastructure

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